Which Is in Worse Shape, U.S. or Europe?

Thursday

Jul 28, 2011 at 6:03 PM

All eyes may be on the debt limit in the United States, but a far more crucial issue is the continuing surge in health-care costs, an economist writes.

SIMON JOHNSON

The United States and Europe seem to be competing hard this summer for the title of "biggest economic problem." Based on the latest news coverage, Europe might seem to be experiencing something of a resurgence, as last week the euro zone agreed on a deal involving mutual support and limiting the fallout from Greece's debt problems.

In contrast, the United States seems to be mired in a political stalemate that becomes more complex and confused at every turn.

But rhetoric masks reality on both sides of the Atlantic. The euro zone still faces an immediate crisis: the can was kicked down the road last week, but not far. The United States, on the other hand, is in much better shape over the next decade than you might think after listening to politicians of any stripe.

American problems loom in the decades that follow 2021, so there is still plenty of time to sort these out; the bad news is that almost no one is talking about the real issues.In a policy paper released by the Peterson Institute for International Economics on July 21, Peter Boone and I went through the details on the euro-zone crisis, including how this common currency area got itself into such deep trouble and what the likely scenarios are now (you can also see the discussion and contrasting views at the publication event). In our assessment, the issue is lack of effective governance within the euro zone. Governments had an incentive to run reckless policy - either in terms of budget deficits (Greece), out-of-control banks (Ireland) or refusal to create an economic structure that would support growth (Portugal).

These policies were financed by loans from other countries, particularly within the euro zone, creating and sustaining the widely shared perception that if any country were to get into trouble, it would be bailed out by deep-pocketed neighbors (a phrase that in this context always means Germany).

At the heart of this system was a great deal of "moral hazard"; investors stopped doing meaningful credit analysis, so Greek or Spanish or Italian governments could borrow at just a few basis points above the rate for the German government (one basis point is a hundredth of a percentage point, 0.01 percent).

What has shocked investors' thinking over the last three years are the realizations that Greece and some other "peripheral" countries have so much debt they may not be able to make all the contracted payments by themselves and that Germany and other northern countries have become convinced that foolish investors should suffer some losses.

Imposing losses on banks that made bad decisions is a sensible principle - but getting from here to there is not easy, particularly when the "periphery" includes Italy, with a far larger economy than Greece or Ireland or Portugal and with gross debt of nearly two trillion euros (about 120 percent of its gross domestic product).

Either Europe really ends moral hazard and widely restructures sovereign debts, or it keeps the bailouts coming, with the deep involvement of the European Central Bank, which will ultimately be inflationary. The package announced last week is a classic case of muddling through; it doesn't really solve anything. (See the Economix Q. & A. on Greece's latest debt deal.)

If Europe and the world now experience a growth miracle, these debt problems will recede in importance, because solvency is all about debt burdens relative to G.D.P. But if near-term growth is not strong, as seems increasingly likely, market participants will soon resume their contemplation of European dominoes.

In contrast, the United States has a simple fiscal problem - as I discussed in my testimony to the House Ways and Means Committee this week. Government debt surged from 2008, not because of Greek-style profligacy but rather because of an Irish-style banking disaster. When credit collapses, so does revenue. As the economy recovers, revenue comes back.

The single most interesting point about today's debt ceiling debate is that over the 10-year forecast horizon that frames for the entire discussion, by any conventional definition no fiscal problem exists. In 2021, the United States is likely to have a small primary surplus at the federal level - meaning that the budget, before interest payments, will no longer be in deficit. (James Kwak elaborates on this point on Baseline Scenario, the blog we run together.)

The really bad budget numbers for the United States come after 2021, but these are not the focus of anyone's current proposals on Capitol Hill. Compared with other countries, the increase in health-care spending from 2010 to 2030 is most troublesome and what will ruin us (see Statistical Table 9 in the International Monetary Fund's Spring 2011 Fiscal Monitor; or, if you prefer a single picture that cuts to the chase, look at where the United States falls in Figure 1 on page 9 of the I.M.F.'s recent report on how to handle "fiscal consolidation" in the Group of 20 developed economies.)

The debate in Washington is both heated and off course, because no one is grappling with the difficult issue of how to control health-care costs. The Tea Party enthusiasts are intent on near-term government spending cuts as a condition of supporting any increase in the debt ceiling.

If this version of a libertarian tax revolt carries the day, the resulting fiscal contraction will slow the economy and fewer jobs will be created. It does nothing directly to address the looming budget issues beyond 2021.

In the near term, the Europeans have the bigger problem - and this will only be compounded by slower growth in the United States (home to about one-quarter of the world economy). Over the longer haul, it remains to be seen when and how politicians in the United States will take up the real budget issues.